Financial Risk Manager Part 1
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An investment analyst is evaluating the performance of a portfolio of small-cap value stocks. They are considering using the Capital Asset Pricing Model (CAPM) and the Fama-French three-factor model to estimate the expected returns of these stocks. Recognizing that small-cap stocks and value stocks have historically outperformed the market, the analyst wants to understand how the Fama-French model might provide a different perspective compared to the CAPM. Which of the following statements correctly describes how the Fama-French three-factor model differs from the CAPM in estimating asset returns?
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TTanishq
A
The Fama-French model incorporates macroeconomic variables, such as inflation and GDP growth, to capture systematic risks not accounted for in the CAPM, which relies solely on the market risk premium.
B
The Fama-French model estimates expected returns by incorporating the effects of macroeconomic variables, such as GDP growth and inflation, alongside market risk.
C
The Fama-French model expands on the CAPM by adding factors related to firm size
Explanation:
Explanation
The Fama-French three-factor model differs from the CAPM in that it adds two additional factors beyond the market risk premium:
- SMB (Small Minus Big) - Captures the size effect (small-cap stocks tend to outperform large-cap stocks)
- HML (High Minus Low) - Captures the value effect (value stocks tend to outperform growth stocks)
Key Differences:
- CAPM uses only one factor: market risk premium (beta)
- Fama-French 3-factor model uses three factors: market risk premium, size factor (SMB), and value factor (HML)
Why Option C is Correct:
- The Fama-French model specifically adds factors related to firm size (SMB) and book-to-market ratio (HML), which are not macroeconomic variables
- This explains why small-cap and value stocks have historically shown different return patterns than what CAPM would predict
Why Options A and B are Incorrect:
- The Fama-French model does NOT incorporate macroeconomic variables like inflation or GDP growth
- These macroeconomic variables are typically used in other models like the Arbitrage Pricing Theory (APT)
- The Fama-French factors are based on empirical anomalies in stock returns, not macroeconomic indicators
For small-cap value stocks specifically, the Fama-French model would likely show positive loadings on both SMB (small size) and HML (value) factors, explaining their historical outperformance that CAPM cannot capture.
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